How the east contributes to wealth inequality

A fire might have been ignited under western Canada when policy makers implemented a business friendly tax structure, but positive investor sentiment is going to take it from campfire to bonfire before the rest of Canada (hereafter, TROC) even gets its matches out of the box. The combination of two recently released reports makes me believe this.

First, The Fraser Institute released its Canadian Provincial Investment Climate Report: 2007 Edition. In it, they publish something called the The Provincial Investment Climate Index, which has seven components: 1. Corporate income tax (CIT), 2. Fiscal prudence, 3. Personal income tax (PIT), 4. Transportation infrastructure, 5. Corporate capital tax (CCT), 6. Labour market regulation, and 7. Burden of regulation

Here’s an abstract from a press release:

The Provincial Investment Climate Index objectively evaluates the public policies that create and sustain a positive investment climate. It ranks each province on a scale of one to 10.

Alberta earned the highest score, 8.9 out of 10, and was clearly Canada's top province for policies that encourage and sustain a positive investment climate. BC followed in second position but some distance behind with a score of 6.0 out of 10. Saskatchewan is third with a score of 5.3 out of 10. The three western provinces were the only ones with an overall score above 5.0.

Ontario was fourth overall with a score of 5.0 while Quebec, with a score of 3.0, was ninth.

Jason Clemens, a co-author of the report, had this to say:

The low scores for Quebec and Ontario are among the most worrying aspects of this year's report. These two provinces are extremely important to the Canadian economy, yet they have chosen to implement policies that are not conducive to attracting investment.

As the west becomes more business friendly, wealth tends to blow that way. But then there's a multiplier effect that kicks in when wealthy westerners begin investing to a degree that surpasses that of individuals elsewhere across Canada.

Earlier this month TD Waterhouse released a report which claims that “…those living in the west are more aggressive investors with higher expectations and greater use of financial plans and advice than those living in Quebec and Atlantic Canada. Ontarian investors, in accordance with their geography, are somewhat in the middle.”

I would attempt to explain this two ways: i) as individuals in the west become more wealthy and more experienced in investing they become less risk averse in their investment strategies; and, ii) we’re seeing that individuals who have a higher propensity to invest also have it in their interest to move, or remain, where the business climate is most attractive: in the west (whether for wage or salary prospects, or for entrepreneurial incentives).

But studies in behavioural economics suggests that there's more here than simply the fact that wealthy westerners will be getting wealthier by putting their money to work. Westerners will also gain experience ahead of TROC. I'm reminded of a paper by Daniel Kahneman where he explains that experienced traders show less reluctance to trade, almost as if they learn to "base their choice on long-term value, rather than on the immediate emotions associated with getting or giving up options." The parallel to the west seems convincing.

Further, while propensity to invest is rocketing in western Canada, it's also the case that in TROC, it's really, really, not. The TD Waterhouse report tells us that “the most favoured type of investment in Quebec is savings held in a savings account (55%).” Talk about low expectations.

The bottom line is that the longer it takes TROC to become business-friendly (or ditch the welfare state sentiment, in the case of some regions), the greater the division of wealth will be across Canada. This will hurt TROC for obvious reasons, and it’ll hurt westerners who will be pressured into being good sports and promoting equality through transfer payments.

Addendum: Damn-it. My images always come out as good as dirt. I vow to work on that at some point.

The underground economy and the poor

Neil Reynolds takes a look at the role that the poor play in the hidden economy.

The Globe and Mail (Jan. 5) ($):

How do poor families spend so much more money than they earn? By one measure — the National Council of Welfare — the average poor Canadian family spends $4,855 a year more than the $14,366 it receives as income, a difference of 33 per cent. By another measure — the Fraser Institute — the average poor Canadian family spends $9,370 more than the $9,114 it receives as income, a difference of more than 100 per cent.

* * * * * *

How does Statscan determine the income of the poor? It asks them. How does it determine the spending of the poor? It asks them. What's the source of the "bonus bucks" that the poor spend? Perhaps, in one of its surveys, Statscan should ask them. We can, meantime, only speculate.

Off-the-table earnings. Wanton use of credit cards. Gifts from more affluent family members. Academic scholarships. (Many postgraduate students are, by LICO logic, poverty-stricken.) But Canada's basic information on poverty remains dubious.

No one knows whether the poor, in their reports, minimize the money they either earn or otherwise get. It shouldn't be surprising if they do. Everyone else does it all the time.

I want to make two points. First, nobody is implying that the underground economy is strictly measuring income concealment, as some detractors seem to be charging. In a 1992 report published by Statistics Canada, "the underground economy" is defined as the mean economic activity that is not measured in the system of national accounts. In the past I may have failed to mention other sources of the "hidden economy" when referring to income concealment, but that’s because I was being sloppy and perhaps aiming for brevity.

Secondly I’ve read quite a few papers recently about different approaches to income concealment (ie. ignoring the rest of the hidden economy). The expenditure approach, developed by Pissarides and Weber (1989), seems to be the most well-received, at least according to the literature that I’ve read (please share your opinion here if you have one!). For example, Pissarides and Weber look at the relationship between income and food expenditures for salary and wage earners to evaluate the "normal" relationship between the two. They then compare this relationship to the income/food expenditure relationship of the self employed. If food expenditure appears to be incredibly high relative to the income level for the self employed, involvement in the hidden economy is assumed.

A major assumption is that the wage and salary earners (in comparison to the self employed) have very little ability to conceal their income (again, never mind their total involvement in the hidden economy), because employers document employees' earnings on their T4 slips. Thus, data from wage and salary earners is assumed to be actual. In relation to Reynold's article, this implies that poor families spend more money than they earn not because they are concealing income, but because of credit, loans, etc.

I have some criticisms of the expenditure approach, only one of which is relevant to Reynold’s article. The expenditure approach often depends on the use of surveys, for lack of other data. But to what extent can we rely on surveys? I have in mind a paper by Elffers, Weigel and Hessing (1987), who found zero correlation between survey results and audits for Dutch taxpayers. If there is zero correlation, even for wage and salary earners (this surprises me), this is a violation of a key assumption of the Pissarides and Weber model.

Further to Elffers et al’s findings, Andrew Jackson at the RPE blog has this to say:

Statistics Canada’s main surveys of consumption patterns are not very reliable, particularly when it comes to measuring the consumption of the very poor. Household surveys (formerly the SCF and the SLID) have been shown by Statistics Canada to produce significantly lower estimates of the incidence of low income than Census and tax data, likely because of under-sampling at the low end of the income distribution. (See Marc Frenette, David Green and Garnett Picot "Rising Income Inequality in the 1990s" in David Green and Jon Kesselman (Eds) Dimensions of Inequality in Canada, UBC Press, 2006.)

While this is a major blow to the expenditure approach (and there are others I won’t bore you with), I have to agree with Mr. Reynolds: i) the data simply does not tell what is hidden; and, ii)if other wage and salary earners are in some way involved in the hidden economy, why assume that the poor are an exception? Jackson’s critical piece on Reynold’s article can be found here.

By the way, if it's ever the case that you're itching to read an available-by-subscription-only article that I refer to, I don't mind emailing it by request.

Tax evasion: lessons from Egypt

In my view, we should be taking a lesson from Egypt when it comes to dealing with tax evasion. I'll explain.

Studies claim that tax evasion among the self employed in Canada is common and the costs are high. What should be done? First, it depends if the government is concerned purely with inefficiency, or if its concern is inequality (which do not need to be trade-offs, as I've argued before here; and I'll point to my view on equality here). I'm going to address the aim of efficiency here, but I'll quickly explain why.

In a welfare state, the objective of an inequality-averse government would be to raise taxes to redistribute incomes, and thus auditing would be useful to protect the tax base. But there are drawbacks to making equality the only major priority. I won't get into the old equality debate again here, but here are a few thoughts: First, when are degrees of inequality aversion sufficient? And, how do we know if such a degree is attainable? Finally, it's worth repeating that, if efficiency is gained, equality does not need to be a trade-off.

My assumption henceforth is that efficiency is the government's concern when it comes to deterring tax evasion.

What actions can the government undertake to increase efficiency? Three possibilities: Do nothing, design an efficient auditing scheme, or cut taxes to a point where the self employed are more willing to pay (and, ultimately, adopt a low flat tax).

Do nothing

If efficiency is the major concern, nothing should be done, claims Simon C. Parker in The Economics of Self Employment and Entrepreneurship (2004: p. 248). Audits are expensive for the government and for the individuals who prepare the tax reports for audits. [edit: My hurried fingers pasted the wrong quote here. Sorry. Intended quote:] "These costs impose deadweight losses on the economy." Parker concludes that a government would be more efficient to not audit.

Design an efficient auditing scheme

Herb J. Schuetze (2002) disagrees. He finds that (at least in Canada) a discriminatory method of auditing would be most effective in reducing tax evasion.

Excerpt from Schuetze's paper "Profiles of Noncompliance Among the Self Employed" (2002, p 19-20) (The entire paper can be found here. Click on "research"):

Even though pre-tax wages will adjust to equalize after-tax wages, too many resources, in terms of efficiency, will be allocated to occupations which provide the greatest opportunities for noncompliance. This result also suggests an obvious strategy for the development of an effective tax audit system. One which targets the self-employed in construction and service occupations is likely to be more effective.

...A tax audit scheme targeting groups which have been found to conceal income the most (such as self employed households headed by younger males or those in the construction and service occupations) is likely to be an effective tool in reducing noncompliance.

He acknowledges a disadvantage:

Clearly, such a policy, if continued for a period of time, would lead to the misrepresentation of occupation and other characteristics by self-employed tax filers to avoid being audited. However, if the information from these audits is used effectively, policies can be designed to reduce noncompliance.

Such a well-designed auditing scheme might be attractive, but perhaps its major disadvantage (other than the one pointed out by Schuetze) is that it's not simplistic. Simplicity in self-employed tax treatment, or any tax treatment for that matter, should be an objective within any economy. By the way, The World Bank agrees with this sentiment (link via The Heritage Foundation) :

Complicated tax systems can lead to high evasion, even when rates are low. ... A better way to meet revenue targets is to encourage tax compliance by keeping rates moderate.

Lower taxes

In my mind, the best solution would be to take a lesson from Egypt. That is, lower taxes to a point where the self employed are willing to pay (zero would be the ultimate). By extension, if taxes for the self employed are to be lower, taxes for all business should be lower. A flat tax seems to be the most efficient, but I digress. Let's get back to Egypt.

Excerpt from "TAX: Abrupt halt to haggling." The Financial Times, Dec. 11:

"The existing culture as far as the tax authority was concerned was a story of predation." says Youssef Boutros Ghali, the finance minister. "Anything the tax authority could squeeze out, it did. But now we have affected a fundamental change of attitude. We have given up predation and established a partnership through a law that is transparent rather than fuzzy and through reducing the tax rate to what people would be willing to part with."

The new law set the top rate at 20 per cent for both individuals and companies, down from 42 per cent. It offered a total amnesty to those who had never filed a return in their lives, regardless of how long they had been earning, if they presented themselves before the end of March 2006.

The law also introduced self-assessment, changing at one fell swoop a system based on the assumption that the tax payer is always a liar, to one in which inspectors have to believe properly-maintained records presented to them, unless they can come up with evidence of wrongdoing.

At the same time penalties for tax evasion have been seriously stiffened. Mr Boutros Ghali says the impact in the first year has been dramatic, with 2.6m returns filed, up from 1.7m in 2005.

The finance ministry had been expecting receipts to drop by 12 per cent in the first year and by 7 per cent in the second before climbing back to their original level at the time the legislation was introduced. Instead, tax receipts have grown by 17 per cent - a reflection of both the wider tax base, and the buoyant economy.

....It is still not uncommon for middle class professionals to argue privately that they should not pay tax, citing examples of official corruption or waste, or to justify tax
evasion by saying that they make no use of the subsidized and generally bad health and education services provided by the government and that, instead, they pay exorbitant fees at private schools and hospitals.

Tax inspectors also say that under-reporting is still rife. One cited the example of a doctor who charged him personally $20 when he went for a consultation, but when he filed his return he listed his fee as less than $4.

No one has any doubts that it will take years for a new tax culture to take roots. But there is agreement that new law is definitely a start.

Now Mr Boutros Ghali says that, with an improved computerised system, and freed of the necessity to check the records of every single taxpayer, his 39,000 inspectors will have more time to chase evaders.

Perhaps we could do better to take our complex tax systems to the trash and keep an eye on Egypt.

Sources of inequality

Recently we saw the release of two interesting reports on household wealth: the Canadian household wealth figures for 2005 from Statistics Canada, and a report from the UN University's World Institute for Development and Economics (WIDE).

The WIDE release and the StatsCan release cover a lot of ground. Incidentally, the StatsCan release is the first of is kind to offer such detailed data on Canada's household wealth distribution since their last such release in 1995 (we're a bit behind the U.S. and the U.K. in the frequency in which we collect this particular type of data). An attempt is made to actually isolate the sources of inequality, which makes for a unique (as far as I know) opportunity for cross country comparisons of sources of inequality.

What can we learn about the sources of inequality of wealth in Canada?

One thing we know is that the middle class holds the majority of their wealth in the form of their principal residence .
Graph via TD
For comparison:

Graph source: WIDE

Secondly, the richest Canadians are likely to hold a greater portion of their wealth in stocks, relative to lower classes.

TD economists Don Drummond and David Tulk offer their analysis on this:

A distinguishing feature of the 1999 and 2005 wealth surveys is the decline in the real value of stock holdings. As the wealthy hold a disproportionate amount of stocks, the decline in the real value is the principal reason why the concentration of wealth in the highest quintile did not increase by more. If investment returns rise the trend towards growing wealth disparities will likely intensify. This could be compounded by sluggish wage gains in the low end and the financial challenge of immigrants – the main source of growth in the younger, less affluent population.

The National Post says tomato differently:

Net wealth -- non-financial and financial assets minus liabilities -- jumped to 640% of annual disposable income in 2005 from 527% in 2000 and just 370% in 1995, when the country was struggling to emerge from a recession.

The surge in wealth in 2005 reflects rising stock markets and once again the positive terms of trade shock where a stronger dollar is making imports cheaper while export prices surge.

That appears to more than offset total debt of 126% of disposable income in 2005.

The point is, the source of household wealth differs across classes in Canada.

I have two thoughts on this. First, equality varies across time and space. Placing countries on an ordinal scale seems bizarre (to me, anyway), likewise to drawing conclusions based on "trends." The richest Canadians hold a high portion their wealth in stocks, which vary in their returns across time, therefore "equality" is not a stationary measure. Further, there's of course often heterogenity in the data across regions. Perhaps one of the key benefits of these studies is that they allow us to examine the nature of sources of wealth, rather than pointing us to "trends," or forcing cross-sectional data into ordinal scales where both are inappropriate beyond very general terms.

Second, there are policy implications. By understanding the sources of inequality we can fight the impulse to redistribute wealth based on "trends." Further, it should be perfectly clear to policy makers that the needs of investors should be accommodated (since we know where household wealth is concentrated). Onay oremay orporatecay axestay. Right? Clear.

There's so much to explore on this subject, but I'll quickly note one of the many interesting aspects of equality: tax shifting, which neither study had anything to say about, unfortunately (but perhaps understandably so in the Canadian context). Alan Reynolds from yesterday's WSJ (h/t Greg Mankiw):

As was well-documented years ago by economists Roger Gordon and Joel Slemrod, a great deal of the apparent increase in reported high incomes has been due to "tax shifting." That is, lower individual tax rates induced thousands of businesses to shift from filing under the corporate tax system to filing under the individual tax system, often as limited liability companies or Subchapter S corporations.

As far as I can tell, this doesn't seem like a big problem in Canada. Jack Mintz and Michael Smart (2001):

Canada integrates corporate and personal taxes by providing a dividend tax credit and excluding a portion of capital gains from taxation. At the small business level, the combined corporate and personal tax rate on equity income is roughly equal to the personal rate on employment and interest income, while for large companies combined tax rates on equity income exceed that of other income. When the small corporate tax rate has been changed in the past, governments have typically adjusted dividend and capital gains tax rates to maintain integration at the small-business level, in order to minimize incentives for shifting between corporate and personal tax bases.

The subject of "equality" often makes me want to rip my hair out, but there are surely thousands of useful, interesting ways to look at it, as StatsCan and WIDE have proven. What a thick and intriguing subject. Please, let's stop dissing it.

Efficiency vs. Equity: Maine and NB

As reported in The Globe and Mail last week, and addressed by Greg Mankiw earlier, two economists have published a paper that compares the extraordinary employment gap between Maine and New Brunswick.

If you provide very generous unemployment insurance, you may end up with more long-term unemployment. That's what economists Peter Kuhn and Chris Riddell find when they compare the long-term impact of a highly generous unemployment insurance (UI) program in the Canadian province of New Brunswick with the more modest UI program in the neighboring state of Maine. In Maine's northernmost countries, about 6.1 percent of employed men worked fewer than 26 weeks (half a year) in 1990. Across the Saint Croix River in New Brunswick, the comparative figure was more than three times as high, 20.8 percent. The more-generous UI program in New Brunswick accounts for about two-thirds of this difference, the authors estimate.

The central message from this study is difficult to argue with: the design of a UI program has a major affect on disincentives to work. It's easy enough to question whether Riddell and Kuhn held all the right factors constant (political and social institutions, taxing policies, nature of industries etc etc). I won't address these here. Further, for the most part, many such concerns seem to be unimportant to the undeniably strong central message.

I have just two comments.

The first is in response to the comments expressed on Greg Mankiw's blog. Several people forwarded the opinion that there is a trade off between equity and efficiency. This annoys me.

A well-designed UI program that promotes efficiency and productivity is promoting equity. Equity has many definitions, but my favorite is this: “a career of hard and responsible work should earn a higher pension than one of slacking or routine casual work.” Thus, equity, according to my favorite definition, encourages efficiency if we assume that individuals are rational and would prefer to earn a higher wage.

In relation to Riddell and Kuhn's findings, I would argue that even a well-designed UI program is destined to produce a poor efficiency and equity outcome in an economically challenged region like N.B. If we accept Okun's Law, it takes 2.5% points of growth above the trend growth rate (which, in N.B., averages 2.25 per cent in the annual real rate over the past five years up to 2005) to lower unemployment by one per cent. With this in mind, efficiency and equity without the promotion of migration is a high goal to set. I don't see how 35,000 unemployed in a labour force of 385,000 in an inviable province signals otherwise. Can equity be achieved in New Brunswick? Well, not through endless ill-efficient subsidization. In sum, the efficiency-equity tradeoff has little grounds.

My second point is this: to what extent does path dependency have an affect on the figures that Riddell and Kuhn arrive at? To explore path dependency, consider the ways that the unproductiveness of the New Brunswick labour force is self-perpetuating. For example, in the time period that members of the New Brunswick labour force are unemployed, their unproductiveness is increasing. Further, the attractiveness of New Brunswick to businesses seeking to establish themselves is decreasing. What is the effect? If such historic trends matter, it must be the case that the 2.5 percentage points of growth necessary (above a declining trend growth rate to put a damper on unemployment by one percentage) is facing upward pressure. How can this not be the case when employment is drastically subsidized, the labour force is decreasing, and the ratio of unemployed to employed is increasing?

A third and a fourth point have popped into mind, but I'll exercise will power and pursue something more productive. This is such a rich subject that I could rant on it forever (at the full risk of contributing nothing new, I might add).

The global redistribution of income

From the PSD blog:

The actual distribution of world income across countries is extremely unequal, much higher than the within country inequality faced by most countries. The question studied in this paper is: How do international policies on aid, trade, and factor movements affect the international distribution of income?… In brief, there is a contradiction in international policies where aid's equality-enhancing effect is somewhat offset by protectionism.
From a new working paper by World Bank chief economist Francois Bourguignon, Victoria Levin, and David Rosenlatt.
Also, the most recent issue of the Journal of World Systems Research is out. It includes papers on global income disparities since 1800 and a review of the economics literature on the world distribution of income and income inequality.